What is an Exchange Traded Fund?
Exchange Traded Fund (ETF) is an investment fund that holds assets, such as: stocks, commodities, bonds, gold bars, and foreign currency. An ETF is traded like a stock throughout the trading day at fluctuating prices. It monitors indexes, such as: Nasdaq, S&P 500, Dow Jones, and Russell 2000. Shareholders of this fund do not directly own the underlying investments, but instead they have an indirect claim and are entitled to only a portion of the profits and residual value in case of fund liquidation. Their ownership shares or interest can be readily bought and sold in the market.
Who are the Authorized Participants in ETF?
As per regulatory directives, Authorized Participants (APs) are designated to create and redeem ETFs. APs are large financial institutions that have huge buying power and market makers, such as: large broker-dealers, and investment banks and companies. In creating the fund, APs assemble the required portfolio of asset components and turn the basket over to the fund in exchange for a number of newly created ETF shares. When the need for redemption arises, APs return the ETF shares to the fund and receive the portfolio basket. Individual investors can participate by using a retail broker who trades in the secondary market.
What are the Different Types of ETFs?
- Stock ETFs – these hold a particular set of equities or stocks and are similar to an index. They can be treated like regular stocks in that they can be sold and purchased for a profit as well as that they carry management fees and expenses much lower than other traded funds.
- Index ETFs – these mimic a specific index like a mutual fund index, but they differ in the way that index ETFS can be bought or sold throughout the trading day. They can cover specific sectors, specific classes of stock, and foreign markets but can only make portfolio changes when changes happen in the underlying index.
- Bond ETFs – these are specifically invested in bonds or fixed-income bonds and can be bought and sold during the trading day.
- Commodity ETFs – hold physical commodities, such as: agricultural goods, natural resources and precious metals.
- Currency ETFs – these are invested as a single currency or a basket of various currencies and are widely used by investors who wish to gain exposure in the foreign exchange market without entering futures or forex. They usually track the most popular international currencies, such as: U.S. dollar, Canadian dollar, Euro, British pound, and Japanese yen.
- Inverse ETFs – funds built by using various derivatives to gain profits through short selling when there is a decline in the value of broad market indexes.
- Actively Managed ETFs – funds being handled by a manager or a team, who decides the allocation of the underlying asset portfolio.
- Leverage ETFs – funds that mostly consist of financial derivatives and debt. These are typically used by traders who are speculative and take advantage of the index’s short term momentum.
- Real Estate ETFs – funds invested in real estate investment trusts (REITs), real estate service firms, and real estate development companies.
What are the Advantages Investing in ETFs?
- Flexibility – ETFs can be traded intraday and shares can be bought or sold at a price throughout the trading day. They can be bought on margins, sold short, or held for a longer time. Since the funds contain baskets of stocks, they normally trade at a much higher volume than individual stocks. This means high liquidity; therefore, investors jump in and out of investment positions to minimize risks and costs.
- Cost efficient – administrative costs are lower, as compared to other actively managed funds. This is due to low management, sponsor fees, and lower sales loads. Also, there are no redemption fees or short-term trading fees, unlike the mutual fund.
- Tax efficient – lower capital gain taxes exist, as there are fewer trades in and out of the fund.
- Diversification – enables investors to easily create a large, diversified portfolio that meets their asset allocation benchmark.